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Tuesday, February 14, 2012

Externalities by Bryan Caplan

Externalities

by Bryan Caplan

Positive
externalities are benefits that are infeasible to charge to provide;
negative externalities are costs that are infeasible to charge to not
provide. Ordinarily, as Adam Smith
explained, selfishness leads markets to produce whatever people want;
to get rich, you have to sell what the public is eager to buy.
Externalities undermine the social benefits of individual selfishness.
If selfish consumers do not have to pay producers for benefits,
they will not pay; and if selfish producers are not paid, they will not
produce. A valuable product fails to appear. The problem, as David
Friedman aptly explains, “is not that one person pays for what someone
else gets but that nobody pays and nobody gets, even though the good is
worth more than it would cost to produce” (Friedman 1996, p. 278).

Admittedly, the real world is rarely
so stark. Most people are not perfectly selfish, and it is usually
feasible to charge consumers for a fraction of the benefit they receive.
Due to piracy, for example, many people who enjoy a CD fail to pay the
artist, which reduces the incentive to record new CDs. But some
incentive to record remains, because many find piracy inconvenient and
others refrain from piracy because they believe it is wrong. The
problem, then, is that externalities lead to what economists call underproduction of CDs rather than the nonexistence of CDs.
Research and development is a
standard example of a positive externality, air pollution of a negative
externality. Ultimately, however, the distinction is semantic. It is
equivalent to say “clean air has positive externalities and so clean air
is underproduced” or “dirty air has negative externalities and so dirty
air is overproduced.”
Economists measure externalities the
same way they measure everything else: according to human beings’
willingness to pay. If one thousand people would pay ten dollars each
for cleaner air, there is a ten-thousand-dollar externality of
pollution. If no one minds dirty air, conversely, no externality
exists. If someone likes dirty air, this unusual person’s willingness to
pay for smog must be subtracted from the rest of the population’s willingness to pay to curtail it.
Externalities are probably the
argument for government intervention that economists most respect.
Externalities are frequently used to justify the government’s ownership
of industries with positive externalities and prohibition of products
with negative externalities. Economically speaking, however, this is
overkill. If laissez-faire—that is, no government intervention—provides
too little education,
the straightforward solution is some form of subsidy to schooling, not
government production of education. Similarly, if laissez-faire provides
too much cocaine, a measured response is to tax it, not ban it
completely.
Especially when faced with
environmental externalities, economists have almost universally objected
to government regulations that mandate specific technologies
(especially “best-available technology”) or business practices. These
approaches make environmental cleanup much more expensive than it has to
be because the cost of reducing pollution varies widely from firm to
firm and from industry to industry. A more efficient solution is to
issue tradable “pollution permits” that add up to the target level of
emissions. Sources able to cheaply curtail their negative externalities
would drastically cut back, selling their permits to less flexible
polluters (Blinder 1987).1
While the concept of externalities
is not very controversial in economics, its application is. Defenders of
free markets usually argue that externalities are manageably small;
critics of free markets see externalities as widespread, even
ubiquitous. The most accepted examples of activities with large
externalities are probably air pollution, violent and property crimes,
and national defense.2
Other common candidates include health care,
education, and the environment, but claims that these are externalities
are much less tenable. Prevention and treatment of contagious disease
has clear externalities, but most health care does not. Educated workers
are more productive, but this benefit is hardly “external”; markets
reward education with higher wages. The externalities of many
environmentalist measures, including national parks, recycling, and
conservation, are hard to discern. The people who enjoy national parks
are visitors, who can easily be charged for admission. If the price of
aluminum cans fails to spark recycling,
that suggests that the cost of recycling—including human effort—is less
than the benefit. Similarly, as long as resources are privately owned,
firms balance their current profits
of logging and drilling against their future profits. If an oil driller
knows that the price of oil will rise sharply in ten years, he has an
incentive to conserve oil instead of selling it today.
Externalities are often blamed for
“market failure,” but they are also a source of government failure. Many
economists who study politics decry the large negative externalities of
voter ignorance. An economic illiterate who votes for protectionism
hurts not just himself but also his fellow citizens (Caplan 2003; Downs
1957). Other economists believe externalities in the budget process
lead to wasteful spending. A congressman who lobbies for federal funds
for his district improves his chances of reelection but hurts the
financial health of the rest of the nation.
Putative externalities have been
found in unlikely places. Some argue that wealth itself has an
externality: inflaming envy. Others maintain that there are
externalities of altruism—when I give money to help the poor, everyone
else who cares about the needy is better off. Defenders of Prohibition
and the war on drugs emphasize the externalities of drunkenness and drug
addiction, though they typically lump private costs, such as low
earnings and unemployment, in with the external costs of drunk driving and violent crime.
In the Big Tobacco class action suit, one of the plaintiffs’ main
arguments was that, given government’s role in medical care, smoking
costs taxpayers money.3
In principle, externalities could be
used to rationalize censorship, persecution of religious minorities,
forced veiling of women, and even South Africa’s apartheid.
If most people were to find Darwinism offensive, the logic of
externalities would recommend a tax on Darwinian expression. Few
economists have pursued such possibilities, probably out of a tacit
sense that, in extreme cases, individual rights override economic efficiency.
Even from a strictly economic point
of view, however, some externalities are not worth correcting. One
reason is that many activities have positive and negative externalities
that roughly cancel out. For example, mowing your lawn has the positive
externality of improving the appearance of your neighborhood and the
negative externality of creating a loud noise. A subsidy or a tax would
alleviate one problem but amplify the other. To take a more
controversial example, some economists question efforts to prevent global warming, calculating that the benefits for people in cold climates more than balance out the costs for people in warm climates.
Another economic rationale for
government inaction is as follows: sometimes an externality is large at
low levels of production but rapidly fades out as the quantity
increases. As long as output is high enough, such externalities can be
safely ignored. For example, during a famine, doubling the supply
of food has large positive externalities because starvation leads to
robbery, hunger riots, and even cannibalism. During times of plenty,
however, doubling the food supply would probably have no noticeable
effect on crime.
Yet, it is to Nobel laureate Ronald Coase
that we owe the most influential argument for letting externalities
solve themselves. In “The Problem of Social Cost” (1960), Coase bypasses
the earlier view that it is literally impossible to charge for some
benefits. Instead, he observes that every exchange has some transactions costs,
which vary from negligible—such as putting coins into a vending
machine—to enormous—such as negotiating a contract with six billion
signatories to improve air quality.
Coase drew strong implications from
his commonsense observation. Instead of arguing about whether or not
something is an “externality,” it is more productive to ask about
transactions costs. If transactions costs are reasonably low, then the
affected parties negotiate tolerably efficient solutions without
government intervention.
To take Coase’s classic example,
suppose that a railroad emits sparks on a farmer’s crops. As long as
transactions costs are low, the railroad and the farmer will work out a
solution. Coase was particularly clever to emphasize that, in terms of
economic efficiency, it does not matter whether the law sides with the
railroad or the farmer. Suppose that it costs one thousand dollars to
control the sparks and the lost crops are worth two thousand dollars.
Even if the law sides with the railroad, the farmer will pay the
railroad to control the sparks. Alternately, suppose that it costs two
thousand dollars to control the sparks, the lost crops are worth only
one thousand, and the law sides with the farmer. Then the railroad pays
the farmer for permission to continue sparking.
Coase’s argument was initially controversial. As George Stigler
recounts in his autobiography, when Coase first presented his idea to a
group of twenty-one colleagues, none agreed. After an evening’s
argument, however, Coase convinced them all. Coase’s approach
subsequently spread widely in both economics and law. Faced with
externalities, modern analysts almost immediately inquire about
transactions costs. For example, in the early 1950s, J. E. Meade
advocated subsidizing apple orchards to correct for the positive
externalities they provide to beekeepers. Inspired by Coase, however,
Steven Cheung (1973) wrote a careful case study of the bee-apple nexus.
In the real world, beekeepers and apple orchard owners do not wait for
government to solve their problem. They can and do negotiate detailed
contracts to deal with externalities.
Coase’s approach is probably the
main reason economists are skeptical of antismoking legislation. While
it is costly for smokers and nonsmokers to directly negotiate with each
other, the owners of bars, restaurants, and workplaces can cheaply
balance their conflicting interests. If nonsmokers are willing to pay
more to avoid the smell of tobacco than smokers are willing to pay to
smoke, restaurants will disallow smoking—and charge a premium for their
smoke-free atmosphere. If unregulated markets fail to deliver a
smoke-free world, Coasean logic suggests that smokers value smoking more
than nonsmokers value not being subjected to cigarette smoke.

About the Author

Bryan Caplan is an associate professor of economics at George Mason University. His Web site is www.bcaplan.com.

Some
economists calculated, however, that the cost of treating
smoking-related disorders was less than the savings attributable to
smokers’ shorter life spans. In other words, it is nonsmoking that has negative externalities! (Viscusi 1994).